CALGARY, Alberta, June 6 (Reuters) - Canada is enjoying an unexpected boom in production of ultra-light crude known as condensate, defying long-held predictions of dwindling supply.

This surprising bounty from one corner of Alberta, better known as the home to Canada’s vast tar-like oil sands reserves, is a boon for firms like Vermilion Energy Inc and Chevron who have built up positions in the Duvernay, now hotly tipped as one of North America’s most exciting shale plays with vast reserves waiting to be tapped.

It also is fuelling hope of cost relief for traditional heavy oil sands companies such as Cenovus Energy Inc, who in the past have paid premiums of up to $25 a barrel to buy imported condensate used to dilute their viscous oil sands production so that it can flow through pipelines.

The change in outlook has been abrupt. A year ago, the Canadian Association of Petroleum Producers expected condensate production to shrink from 139,000 barrels per day to barely 100,000 bpd by 2025, according to its annual forecast.

The group’s updated forecasts, due out next week, will likely show a very different trajectory, according to Greg Stringham, vice president of oil sands and markets.

“(Condensate) had been in decline. We are now seeing relatively strong growth,” he said. He declined to give exact numbers until the report is released on Monday. In April, Canada’s National Energy Board said it expected output to rise 13 percent this year to 172,000 bpd.

While the growth is modest compared to the shale revolution that is upending the U.S. industry in places like North Dakota and Texas, its impact may reverberate far south of the border.

Rising domestic supply is coming at a time of lower than expected demand for imported U.S. diluent because more companies are moving to ship bitumen by rail, which doesn’t necessarily need to be diluted, instead of pipeline.

As a result, the trends may further depress U.S. condensate prices and thus add to mounting political pressure to relax U.S. rules barring overseas exports.

Along with a newly reversed Cochin pipeline that will start delivering up to 95,000 barrels per day of U.S. condensate from Illinois to Alberta in July, some producers are growing hopeful that prices may finally begin to ease.

“I don’t believe there’s such a thing as cheap condensate. But all other things being equal, more supply coming into the basin should be a positive thing for the buyer,” said Rick Dembicki, director of crude oil marketing at Cenovus, which sources half its condensate from outside the province.

A LONG WAY TO DUVERNAY

Condensate supply, though small, plays a critical role in the growth of Canadian oil sands, the world’s third-largest crude reserves behind Saudi Arabia and Venezuela.

Because raw bitumen is too heavy and thick to flow easily through pipelines, it must be blended with around 30 percent of a lighter oil, known as diluent. A number of different types of hydrocarbons can do the job - including condensate, natural gasoline and synthetic crude oil. The diluent is then stripped out by refiners or terminal operators at the destination, often to be pumped back to Canada and blended again.

With oil sands production expected to nearly double over the next decade, demand for diluent is expected to surge to around 900,000 bpd in 2025, consultancy Wood Mackenzie said. Other forecasters suspect demand will be over 1 million bpd.

Thanks to the recent boom in the Duvernay formation, a growing share of that may be met with Canadian condensate.

Last month, Canada’s Encana Corp said the northern Simonette area of the Duvernay was producing up to 400 barrels of liquids per million cubic feet of gas, more than twice the 150 barrels per million it had expected.

Chevron’s well performance and yields in the Duvernay had exceeded expectations with initial production rates of 1,300 barrels of condensate per day, Jeff Shellebarger, North America Exploration and Production, said last October. A Chevron spokesman said that was the latest production estimate.

Western Canada could produce 375,000 bpd of condensate by 2025, with 200,000 bpd coming from the Duvernay under the most optimistic scenario, said Wood Mackenzie analyst Mark Oberstoetter.

“That will mean less money that Alberta operators will have to pay in the United States to ship it up,” Oberstoetter said.

DIFFS AT A DISCOUNT

At the moment Canada uses for diluent about 200,000 to 250,000 bpd of condensate, most of that imported from the United States. Much of it travels more than 4,000 kilometres (2,485 miles) from the U.S. Gulf Coast, where supply is abundant. The added transport costs mean condensate has typically commanded a premium in Alberta, though it trades at a discount in Texas.

Because supplies are tight and existing pipeline shipments can be difficult to predict, prices are often volatile. At times condensate in the Alberta trading hub of Edmonton spiked as high as $25 per barrel over U.S. benchmark futures about five years ago and in recent years premiums have touched $15 dollars.

But the growth in local production coupled with the rise of oil-by-rail and the imminent reversal of Kinder Morgan Energy Partners LP’s Cochin pipeline may shave that.

The premium dropped from an average of $10.23 per barrel in 2011 to $3.72 per barrel in 2013, according to a presentation from Cenovus. On Thursday, condensate was pegged at a $3 discount because of strong supply from the 180,000 bpd Enbridge Inc Southern Lights pipeline from Chicago, Illinois, and lower blending requirements during the warm summer months.

“The price of condensate has historically been plus $5 to $10 per barrel. I think that’s a thing of the past and it’s dropping to par with WTI,” said John Homan, senior marketing and logistics representative at Calgary-based Laricina Energy Ltd.

RAIL DENTS DEMAND

For the moment, the growth in Canadian output looks too minimal to disrupt plans for more imports, such as the Cochin reversal and a proposal by Enbridge to boost capacity on its Southern Lights pipeline to 275,000 bpd.

But demand forecasts are in flux as producers look for innovative ways to trim their use of the costly diluent. More companies are embracing rail as an alternative to congested crude export pipelines and using heated and coiled cars to ship bitumen raw, requiring no diluent, or as “railbit,” which blends just under 20 percent diluent into each barrel.

An estimated 1.1 million bpd of rail loading capacity will be available in Western Canada by year-end, if proposed terminal projects stick to construction schedules.

Companies such MEG Energy and Gibson Energy Inc are running pilot projects to develop partial upgrading technology and diluent recovery units that would also reduce demand. Meanwhile, on the supply side CNOOC Ltd subsidiary Nexen Inc is selling light oil from its Long Lake project into the Alberta diluent market. (Reporting by Nia Williams in Calgary, editing by Jessica Resnick-Ault, Jonathan Leff and Cynthia Osterman)